18.III.2.1.2 Pre-trade transparency: liquidity and the nature and size of the venue

Experience from the ISD to MiFID II demonstrates that, in the opinion of the EU, two factors of the market microstructure are of particular relevance for the optimal amount of equity pre-trade transparency. The two factors are: (1) liquidity;1 and (2) the nature and size of the venue operating the market microstructure. When trading becomes more liquid, the trading process naturally evolves towards a market microstructure where supply and demand are matched without a specific risk-taking intermediary that provides liquidity by trading on own account. By contrast, when liquidity shrinks, a specific risk-taking intermediary, such as a market maker, becomes more important.2

The second element of the market microstructure is the nature and size of the venue. Already under the ISD, FESCO recognised that, besides RMs, also platforms executing orders outside RMs can be relevant for price formation ‘depending on the size and nature of their activities’.3 MiFID I and MiFID II institutionalised FESCO’s statements through pre-trade transparency rules for RMs and MTFs and SIs.4 The EU considers MTFs to represent the same trading functionality as RMs (nature),5 which resulted in a similar pre-trade transparency regime for RMs and MTFs under MiFID I. MiFID II has a similar approach by subjecting RMs and MTFs to the same pre-trade transparency regime.6

The situation was less straightforward when it came to introducing pre-trade transparency rules for SIs under MiFID I. Clashes between the market-led and market-shaping philosophies resulted in a compromise as to the MiFID I pre-trade transparency rules for SIs. The market-shaping philosophy argued that internalisation encompassed risks for price formation and accordingly pre-trade transparency rules were necessary, whereas the market-led philosophy emphasized position risks of internalisation (i.e. position risks due to executing client orders by trading on own account) and claimed that post-trade transparency rules would be sufficient.7 The compromise under MiFID I was that where internalisation (nature) was systematic, frequent, and regular (size) pre-trade transparency rules applied, provided certain conditions were met.8 Concerning SIs, MiFID II adds a quantitative element.9 The effect of MiFID II is that, besides the nature of the activity (internalisation), size has become of greater importance in determining the optimal degree of equity pre-trade transparency.